In today’s Exponential Investor:

  • What is ESG?
  • Does ESG investing work?
  • What moves the ESG investment barometer?

Last week, my colleague James Early penned an outstanding piece on ESG investing (more on what it means to follow).

James is our editor of Southbank investment Daily and the host of The Early Advantage, which you can view – and then subscribe to – here.

When I was alerted to and then read his ESG essay, I knew immediately that I had to send it out to you.

Thanks to my persuasion skills, James has very generously agreed to let us republish his wonderful essay here at Exponential Investor.

Usually, Southbank Investment Daily pieces are reserved exclusively for our investment advisory subscribers, and not included in our free e-letters. However, today you get an inside look as James’ excellent analysis and expertise on the markets.

Sit back, read on, and enjoy what he has to say on ESG investing…

Sam Volkering
Editor, Exponential Investor


Does ESG actually work?


Environmental, social and governance (ESG) investing is having an existential crisis.

Or at least an identity crisis.

On one hand, ESG assets are predicted to be half of professionally managed assets by 2024, according to Deloitte. That’s in just 1.5 years. And a full 22% of all funds launched in the United States in 2022 carried the ESG label.

On the other hand, with many shares down this year – with the exception of oil and gas shares, which many ESG funds eschew – ESG has underperformed recently. Forbes cites Morningstar estimates that ESG fund inflows dropped 36% in the first quarter of 2022.

And then there’s regulation. With ESG having been red hot until very recently – especially amongst millennial investors – investment companies scrambled to be as ESG as possible. Except that some weren’t. In the United States, the SEC cracked down on “greenwashing,” and European regulators, fuelled in particular by a Deutsche Bank ESG scandal, are tightening the leash as well.

I thought it might be useful to walk through a few thought pieces on ESG.

What is ESG?

ESG standards for environmental, social, and governance. Its precursor acronym was SRI, or socially responsible investing. Humans have been guiding their money for religious reasons for thousands of years. Because the Quakers in the early United States (well, before they even were the United States) banned investments associated with slavery, and Methodists restricted those with tobacco and alcohol, these early Christian groups are generally credited with ushering in the “modern” ESG era in the Western world.

Does ESG work?

It’s hard to answer. As the growth numbers show, there’s definitely an enormous desire to invest in a way that makes the world better.

But is ESG really routing money away from undeserving things and into deserving things? And if it is, is that routing making a difference?

That’s still hard to answer.

There appear to be some success stories: Engine One, a small ESG hedge fund, successfully waged a campaign that, thanks to the help of larger shareholders like BlackRock, pushed Exxon Mobil to reduce its carbon footprint.

This is a clear win in the sense of an ESG investor pushing a big company to do something ESG. But the guy on the right of this video says that Exxon Mobil’s 20% production cut just left more business on the table for the far-less-ESG-y PetroChina. (If you’re new to ESG, it may be tempting to watch that video and conclude that ESG investing, or at least ESG opining, is a young man’s sport.)

What if PetroChina one day also gets ESG pressure? China, which strongly prioritises nationalist interests over essentially everything else, may be a difficult example, but one argument may be that whilst it’s hard to attribute success to individual ESG campaigns, ESG doubles as a gauge of popular sentiment that has become mainstream enough to create economic reality.

Here’s a case in point: Goldman Sachs’ and JP Morgan’s decisions to stop financing arctic drilling, for example, delighted the ESG crowd, but didn’t seem due, or at least largely due, to specific pressure from the companies’ ESG-minded shareholders. Rather, they were more likely responses to the banks’ general fears of what might happen if they didn’t act – i.e. knock-on effects from the broader financial ecosystem for abetting a controversial practice. This being effects from their own shareholders, but also from current and prospective investment banking clients (who in turn were probably worried about their own knock-on effects), retail customers, protests and protest media coverage, lawsuits, etc.

ESG has certainly made money for investment companies and ratings agencies, and tends to make ESG investors feel good about how they’re investing. This is why ESG is hugely popular, after all.

But accounts on how well ESG investing performs in a returns sense are mixed; many papers support the notion that ESG investing does well, but my academic friends tell me that at least some of these papers – which tend to be lauded at ESG conferences and by media – are not known for their analytical heft. And the more ESG becomes everything and everything becomes ESG, the harder divining true ESG performance becomes.

How did Tesla get kicked out of the S&P ESG index while Exxon Mobil remained, and why was British American Tobacco named a top 3 FTSE ESG company?

I trust that you will excuse the directness of the following question, but it has to be asked: are ESG ratings crap, in other words? There are more than 160 ESG ratings companies according to Bloomberg, which itself provides ESG ratings. Each with a different way to rate. On top of that, there are multiple styles of ESG. And on top of that, there are those that define ESG rating as maximising do-gooder-ness (the old-school way) and those that measure ESG in terms of the risks ESG factors pose to the sustainability of the company (the path-of-less-resistance new-school way).

ESG itself is highly subjective. The “E” is seen as the most cut-and-dried, whereas the social and governance parts – the main reasons S&P seems to have dinged Tesla, despite its overall reputation for bringing mankind into the era of electric vehicles – are the most subjective.  Likewise British American Tobacco makes a product that shortens lives, but it does tick a lot of boxes that ratings agencies like: movement toward carbon neutrality and renewable energy, human rights focus, being a good water steward, and efforts to reduce tobacco’s portion of its business.

MSCI dominates ESG ratings with 40% of the market; Bloomberg did a semi-expose on the ESG ratings business, finding some inconsistencies.

Is it better to reward absolute ESG-ness or relative movement toward ESG ends?

At first it seems laughable that a tobacco company or an oil company should have anything to do with ESG. But there’s an argument that a big, bad company’s becoming less bad is a greater contribution to world improvement than a small ESG-ish company doing everything right from the outset.

So now there’s an emergent and sometimes-mocked class of ESG funds that pick what look like the least ESG-ish companies around, but their logic is to reward – and hopefully benefit economically from – progress made by those companies who most need to make progress. It’s a bit like how reductions in obesity and smoking may do more for public health than making the personal trainers even fitter.

Are defence shares ESG if we decide we suddenly need defence?

If you read my column a few months ago, you know that Citigroup, the EU Platform on Sustainable Finance and others were, now that Russia invaded Ukraine and seems more threatening to Europe, deciding if defence companies – traditionally ESG pariahs – now belong in ESG portfolios. (Incidentally, MSCI had previously given Russian bonds a fairly good ESG rating, and only initially downgraded them halfway after the invasion.)

Critics call this ESG hypocrisy on full display. I’m trying to be unbiased, but I tend to agree with those critics on this point. If anything, it underscores that ESG is subject to the same cognitive biases as humans – and humans have quite a few.

Don’t ESG funds just create opportunities for non-ESG investors, and/or just move non-ESG business practices to private owners or authoritarian domiciles?

I suppose this is game theory. In a localised sense, if a group of investors sees a potentially good-returning investment but shies away from it for ESG reasons, its price will drop – initially. But unless the eventual profitability of the business has been impaired as well (likely a point of debate in an ESG context), the now-lower price presents an opportunity for an even better return for whoever is willing to hold his nose and buy.

So, returning to game theory, this situation needs a cartel to truly “punish” the bad company – much like how sanctions (controversial in their own right) would work best if they’re truly enforced in unison, and don’t work as well if someone is cheating or if the sanctioned country has other avenues of trade.

In a sense, this brings us back to the idea that ESG, at a minimum, is a broad barometer. If a nation, or some very large group of investors shares the same knowledge and values, that collective mindset may start to work like a cartel.

At least in theory.

Wouldn’t policy changes do a better job of effecting the types of things that ESG investors want?

This is a million-pound question – and one we’ll get to next time!

James Early
Editor, Southbank Investment Daily